Sarbox’s Unseen Costs

''The crucial unseen cost is that of innovations foregone or delayed,'' says a reader. More letters to the editor: Microsoft on options; thoughts on Black-Scholes; expensing flaw; the root of the problem.

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Please include your full name, title, company name, address, and telephone number. Letters are subject to editing for clarity and length.

Sarbox’s Unseen Costs

I applaud your article detailing the costs the Sarbanes-Oxley Act of 2002 has imposed on public companies in the United States (“Sticker Shock,” September). The article is one of only a few to raise the question of whether the costs of Sarbanes-Oxley compliance are worth the benefits. And it points out that the direct costs are measurable, but the benefits are not. Although executive agencies are obliged to estimate costs and benefits when promulgating regulations, Congress is not under such a stricture. Sarbanes-Oxley is the result.

The most significant costs wrought by Sarbanes-Oxley are those not readily seen. The crucial unseen cost is that of innovations foregone or delayed because resources for research and development are being used instead to pay for Sarbanes-Oxley compliance. Who would have chosen to delay by months or years the development of Prozac, Zithromax, or the insulin pump in favor of having the CEOs and CFOs of the companies responsible for the products certify the companies’ financial statements?

Another important and related unseen cost is the cost of companies choosing not to become public, because of the costs of being public. By raising the cost of directors’ and officers’ insurance, accounting, hiring able executives, and populating the board and board committees with able directors, Sarbanes-Oxley has made raising capital in an initial public offering more expensive and difficult, thereby reducing the capital available to finance young, innovative companies that drive technological advances.

Many less-costly proposals for encouraging enhanced disclosure and curtailing corporate fraud have been advanced, such as empowering the stock exchanges to choose rules that investors value highest relative to the cost imposed on listed companies, and better enforcement of existing antifraud rules. Such rules have the benefit of an agency weighing costs and benefits before burdening productive people and capital with costs without any discernible benefit. Congress would do well to first consider ways to stimulate corporate entrepreneurism and innovation before smothering them under a mountain of compliance.

It is important to remember that the problem being addressed by Sarbanes-Oxley also has a very high cost. Some of the recent frauds caused companies’ market values to drop by $10 billion or more. In addition, widespread decreased confidence in the financial markets due to all of the accounting scandals certainly played a role in the U.S. equity markets losing a significant portion of their value in recent periods. If we add job losses, creditor losses, and so on, the cost of accounting fraud can be staggering—in the tens of billions of dollars for large frauds.

How much will Sarbanes-Oxley compliance really cost the United States? To get a “ballpark” number, I used the data in your questionnaire (question 3 in “Sticker Shock“) to extrapolate your respondents’ estimated compliance costs to the population of about 15,000 U.S. public companies. For example, for the “less than $500,000” cost category, I took $250,000 (the midpoint) times 52 percent times 15,000 companies. Doing this for all five categories (using $8 million as the midpoint for the “more than $5 million” cost category) produces an estimate of about $15 billion for all public companies to comply with Sarbanes-Oxley for the first year—and this method likely produces an estimate on the high side. To put this $15 billion in perspective, if Sarbanes-Oxley can prevent one large fraud in its first year, you could argue that the legislation pays for itself—and annual compliance costs in later years are expected to decline.

A main thrust of Sarbanes-Oxley is Section 404 on internal controls. Stronger internal controls are designed to increase the reliability of financial reporting (that is, reduce the risk of fraud and other misstatements), and I believe that the intense focus on controls may push many companies’ cultures toward greater accounting conservatism and transparency. Despite all of the complaining we hear, I think Sarbanes-Oxley could turn out to be relatively cheap medicine for our “fraud influenza.”

Dana R. HermansonProfessor of AccountingKennesaw State UniversityResearch Fellow, Corporate Governance Center at the University of TennesseeKennesaw, Georgia

Microsoft on Options

Microsoft appreciates the opportunity to point out what we believe to be misleading conclusions in “Windows into Valuation.” The article attempts to compare the Black-Scholes value of Microsoft employee stock options to the value employees would receive under a recently proposed stock-option transfer program. For instance, while the table included with the article correctly points out that the Black-Scholes values are based on disclosures in Microsoft’s 2002 10-K, the calculation of those values appears to use the expected life of the options at the time they were granted, without addressing the fact that the options have been outstanding for a period of time, and therefore a shorter life would be appropriate.

In addition, the Black-Scholes amounts referenced in the article do not take into account other critical assumptions, such as for options transferred under the program, the period until maturity will generally be shortened and the terms will be changed to conform to the terms of options typically issued to financial institutions. Without taking into account these assumptions, the table greatly exaggerates the Black-Scholes value of the options eligible to be transferred. Accordingly, we do not believe the proposed stock-option transfer program either proves or disproves that existing pricing models overvalue options.

After reading yet another article on the debate over the expensing of stock options (“Who Rules Accounting?“), I have to wonder if I am the only one who likens the debate to a crowd of people discussing the fit and style of the emperor’s new clothes.

It seems everyone is weighing in on this subject, including such accounting luminaries as Ralph Nader and Sen. John McCain—and almost nowhere do we hear much about the serious deficiencies in measuring the value of stock options using the Black-Scholes Option Pricing Method (the “B-S” Method).

The B-S Method is a complicated set of equations that use many different inputs to generate a theoretical estimate of the value of the options that have been granted. The first deficiency is that the many inputs to the equations are also estimates, all of which can be manipulated. The second, more serious deficiency is that under current GAAP, at no time is this theoretical value ever “trued up” to the actual underlying value that is transferred.

Take, for example, two companies that grant vested employee options valued at $10,000 using the B-S Method. For one, the employee leaves a month later and the options are forfeited. For the other, the stock skyrockets and the options are subsequently exercised for a million-dollar profit. Under current GAAP, these two transactions would be treated as identical, because the options both had a theoretical value of $10,000 at the time they were granted.

The economic reality is that stock options may provide incentive when granted, but no permanent economic benefit is transferred until they are exercised—just ask all of those high-tech workers with worthless options. And upon exercise, it is very easy to measure the value that has been transferred from the stockholders to the optionee. I believe investors would be better served by having this information, rather than the meaningless numbers that are currently recorded or disclosed.

Further, because the B-S Method is so widely used, nonaccountants may reasonably reach the conclusion that companies that do not expense their options are hiding something. I think that if the Financial Accounting Standards Board won’t take this issue seriously, the business community and the accounting profession should. Leaving the issue to politicians and pundits is endangering the accuracy of the financial information our system is based on.

The goal of accounting and financial reporting ought to be to measure with accuracy the economic transactions that are taking place. I think FASB and the Securities and Exchange Commission need to be reminded of this—and that’s no “B-S.”

Michael FriedlVia E-mail

Expensing Flaw

The movement to force the expensing of options should be delayed and appropriately studied. If the Securities and Exchange Commission or the Financial Accounting Standards Board proposes fundamentally flawed actions, it may well be appropriate for Congress or others to block these actions.

For the first year or so of the campaign to require that options be expensed, various articles presented vaguely convincing arguments supporting both sides of the question. Now the theme of most of the literature is captured in your editorial (“Days of Future Past“): expensing is correct and we should do it now.

The flaw I see in this is that the expense of options is not borne by the company issuing the options. When “in the money” options are exercised, the flow of funds is from the “market” to the company (the issue or strike price) and to the holder of the option (the premium). The dilutive effects of this action are already represented in the EPS numbers reported. So why should another charge be taken to earnings?

The abuse of options as compensation is a problem, and has caused some of the illegal and unethical actions taken by corporate executives. Full disclosure and possible legal restraints may limit this abuse. But further blurring of corporate financial performance through arbitrary “expense” additions doesn’t seem to address the issue.

John BlairCarefree, Arizona

The Root of the Problem

Kris Frieswick’s article “How Audits Must Change” was well written and quite informative. I wonder, however, if the basis of the piece should have begun with the last sentence, which stated: “Critics say that perhaps [the American Institute of Certified Public Accountants] was the root of the problem all along.”

For the past 40 years or more, the AICPA has been aiding and abetting (if not masterminding, probably inadvertently) the events that have led to the current disgraces that we continue to hear about every day. True, the dollar values and the abuses were smaller, but they were allowed to build and build. And each time a problem came to the fore, the AICPA came up with a public-relations masterpiece that was designed to convince Congress and the public that the organization had the problem solved and contained.

Self-regulation was the mantra. The AICPA would see to it that these debacles would cease. Peer review, mandated continuing professional education, and similar cures were advanced in the interest of the profession and the public.

Each time new fiascos occurred, the AICPA would gather the PR wagons in a circle and publicize the fantastic job it was going to do to prevent them from ever happening again. Self-regulation, in a new design, would save the day.

Of course, self-regulation never worked. The perpetrators were never severely admonished or punished. There were never “audit failures,” only “business failures.”

So the large firms became emboldened, and greedy. Since they could do no wrong, they could get away with whatever they chose to do. They aided and abetted their clients, they looked the other way, they overlooked basic audit procedures, they bypassed immaterial items (such as $6 billion of overstated income), and they received consulting engagements beyond their wildest dreams. Ethics and conflict of interest were old-fashioned ideas that had little relevance in a market-driven economy.

Chances are that if Enron hadn’t invested its employees’ stock in the company’s 401(k) plan, Congress wouldn’t have gotten so bent out of shape and jumped into the act. Why, only 10 months before the Enron collapse, when [then] Securities and Exchange Commission chairman Arthur Levitt tried to correct some of the abuses, the Big Whatever and the AICPA called in their PAC markers and got Congress to pressure Mr. Levitt to back down. (Today, these same members of Congress are screaming that the accounting profession has to be severely regulated.) Levitt’s reprimand of the AICPA for failing to self-regulate the profession and provide ethical leadership fell on deaf ears.